Real-Fiscal Linkages of Fiscal Revenue-side in Iran

In many developing countries, a critical challenge arises when they aim for economic growth through capital accumulation. This often leads to the necessity of creating budget deficits to fund their development costs. There are several reasons for this: 1) The tax bases are not sufficient to impose a high tax burden; 2) The tax administrative organizations are inefficient in utilizing the available tax bases; or 3) Political constraints make it impossible to impose a high tax burden. In the absence of developed capital markets to provide enough external funding, government budget deficits are often funded by central banks through money creation. This process of money printing leads to a rise in the overall price level and, in turn, causes a decrease in the actual value of the currency. Consequently, as suggested by Tanzi (1978), the government’s revenue may be negatively affected by this inflationary increase. Therefore, in an imaginary economy, if only the Tanzi effect is present, the government is likely to be the biggest loser from inflation; but why in many developing countries, such as Iran, does the government not want or cannot seriously reduce inflation?

Furthermore, in an imaginary development-friendly economy, one would expect the government to influence real-fiscal linkages in a way that maximizes the encouragement of economic growth and development. Yet again, the question arises: why in these countries is sustained high economic growth, a high degree of openness to trade, the design of a progressive income tax system, political, fiscal, and demographic decentralization, and optimal government size are not observed? Hence, the progress towards a government with fiscal soundness and a well-developed economy has been uncommon in the historical growth path of developing countries worldwide.

This paper seeks to address the following questions: Has the Iranian government faced challenges on the revenue-side of its budget due to the persistence of high inflation in its economy? Furthermore, how have other real-fiscal linkages affected the government's revenue-side?

This paper, by maximizing a generalized model of Tanzi’s simplified initial model (1978), in addition to providing a more comprehensive explanation of real-fiscal linkages, models the link between the phenomenon of fiscal lags and fiscal drag. Then, it empirically identifies the macroeconomic determinants of the government's revenue-side in Iran from 1972 to 2020 using the Dynamic OrdiDOLS method and employing a specific-to-general modeling approach.

The findings indicate that inflation, centralization, deviations of public goods prices from market prices, and a concentration of tax collection on labor income tax have had positive effects on government revenue in Iran. Contrarily, economic growth and trade openness have had negative effects on government revenue. In fact, the effects of economic growth, inflation, trade openness, population density, the relative size of the employed population, and the relative size of the public sector all indicate the presence of strong “anti-development” political economy incentives in Iran’s governance. Therefore, from a political economy perspective, such a government has strong incentives that discourage growth, prevent the inflation rate from falling below a certain level, do not promote decentralization in favor of the periphery, do not broadly levy taxes on “net wealth changes”, and do not compel public institutions to follow free market relative prices; even though there may be regulations in development plans and other agendas that contradict these. Hence, before designing any economic growth strategy, it is necessary to architect the economic system in a way that eliminates these political economy incentives, which are the root cause of Iran’s economic growth lagging. Afterward, it is essential to design and implement a growth strategy that is both internally and externally comprehensive and coherent.